Sector Funds: Do You Know What You're Getting Into?

Unlike diversified stock funds, which hold stocks from a wide range of industries, sector funds buy stocks in only one area, such as health care, or an even narrower slice of the health care pie, such as biotechnology. Due to their narrow focus, sector funds tend to be mercurial, with higher highs and lower lows than diversified funds. That's why most financial advisers and asset-allocation models suggest you devote no more than 5% to 10% of your portfolio to a sector investment -- mainly because your diversified funds probably already give you significant exposure to each sector anyway.

Before you start sifting through the myriad and sometimes confusing sector-fund bins, here are a few tips and a quick look at what you might find in each:

Beware of misleading labels:

Marketers, not portfolio managers, usually christen funds, so their names often have little to do with where they invest. "Global" sector funds often have few foreign holdings, for instance. So, as usual, closely read a fund's prospectus and check out its holdings before you buy.

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Buy the manager and the firm:

When it comes to sector investing, generalists need not apply. Look for managers who have successfully run funds in the particular sector for at least three years. Also focus on firms with a solid reputation for running funds in that sector or using that investment style. Buying a tech fund run by a shop known for value investing, which currently focuses on sleepier areas like financial services, often isn't a great idea.

Look for best- and worst-case scenarios:

Industries can change in a hurry -- deregulation is making financial and utility stocks higher octane than before -- so it's best to pick a manager who's weathered shifts in an industry's fortunes. How do you know if he or she has held up under that strain? Call up the fund company and ask for the fund's three worst quarterly losses. That'll give you a real-world idea of how bad things could get.

Don't bother unless you're in it for the long haul:

Most financial advisers say you shouldn't buy a sector fund unless you're prepared to have money in that niche for 10 years. That long horizon makes the inevitable short-term selloffs easier to swallow.

Sector Category Tips:

Technology

Here you'll find some of the most diversified sector funds around and also some of the most narrowly focused. Fewer than half the tech funds out there have been around for less than three years, so if you're looking for a broad fund you might want to use that time frame as your first screen for both fund and manager longevity. Farther back, look for managers whose funds held up well in a mediocre year like 1994 and didn't explode after 1999's dazzling returns. If you're looking to focus, you can find funds that zero in on the Internet, e-commerce and networking -- essentially the Ciscos (CSCO) of the world who help the Net and company networks work more quickly and more reliably. But beware: These ultra-focused funds will often be as volatile as stocks.

Health Care

Essentially you have two choices: broad exposure or biotechnology. Broad health care funds can spread their money among hospitals, health maintenance organizations and medical insurers, as well as companies that make or sell drugs, and medical devices. If you want to swing for the seats, you might look at biotechnology funds, which primarily focus on cutting-edge shops that develop new drugs. These often have "biotechnology" in their names, a focus on smaller companies and a particularly high return in 1999. If you want to focus on other subsectors, you might look at Fidelity's Select funds, which carve the industry into thin slices.

Telecommunications

Years ago this was a widows-and-orphans sector comprising dividend-rich old-line shops that provided local and long-distance phone service. Now, while they fight for the slow-growing voice-phone business, old-line shops as a host of new firms are also battling for the much-sexier Net access and wireless voice-and-data transmission business. Whether you're looking for a broad fund or a more aggressive tech/telecom option, a fund's holdings and volatility should tell you exactly what you're looking at.

Financial Services/Real Estate

In this bin you'll find funds that focus strictly on banks, insurers and real estate investment trusts, or REITs, as well as broad funds that also hold brokerages, money managers and all-in-one behemoths like Citigroup (C). The main idea with investing in financial services is that they're steady, if somewhat modest, growers that can lead to big profits as they routinely merge to build a bigger customer base and matching profits. Recent deregulation paves the way for more consolidation, but keep in mind that rising interest rates almost always send the sector down, because they eat into profits. A broader fund, particularly one that held up during a rocky 1998 and 1999, might be a good way to profit from this trend and diversify a tech-heavy portfolio.

Utilities

Like financial services, deregulation has fundamentally changed this industry and the funds that invest in it. Rising competition among companies that provide homes and businesses with electricity and natural gas has led to consolidation. Many formerly stodgy utilities funds also have gorged on telecommunications companies, including the aggressive wireless set. No matter what you want from your utilities fund, x-ray its holdings and investment style before you buy. Otherwise, you could end easily end up with more risk than you want.

Natural Resources

This vast category can invest in companies from the mining, oil, natural gas, chemical and forestry industries, among others. If there's a unifying factor here, it's that most of these funds live and die with commodities prices. Rising prices boost profits and widen margins; falling prices are usually bad news. Before you buy one of these, check out how the fund fared in 1994 and 1998 when the category hit choppy water.

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